Why target-date funds could miss the bull’s-eye

Arends: Study casts doubt on so-called ‘glide path’ for investors

Some years ago, the money-management industry tried to engineer a single investment solution that could be applied to “everybody” on Main Street and came up with the idea of the “target date” mutual fund. These funds come under a variety of different names, but at heart they operate the same way. A target-date fund is a one-decision mutual fund that you can invest in over the course of your entire career.

Each fund is designed for those aiming to retire at a certain date. The fund starts with a lot of “risky” stocks, and over time it moves to “safer” bonds. The fundamental idea is that at any given moment between age 21 and age 65 you should be invested in a particular balance of assets — more stocks when you are younger, and more bonds when you are older.

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The track to retirement, according to the industry jargon, is a “glide path.”

How nice. How smooth. How secure.

Billions of dollars are invested in these target-date funds. They are today the default investment option in many 401(k) plans. Now comes Rob Arnott, the chairman of Research Affiliates and one of the handful of serious money managers in the country. In a new research paper he published yesterday, “The Glidepath Illusion,” he has blown this idea full of holes. “Shockingly,” he says, “the basic premise upon which these billions [of dollars] are invested is flawed.”

Arnott has mined data from the stock and bond markets going back to 1871 and then run simulations to see how these target-date portfolios would have worked in practice. He considered a fund that started out with 80% stocks and 20% bonds, and then adjusted gradually over an investing life of 41 years so that it ended up 80% bonds and 20% stocks. He considered an investor who invested $1,000 a year, adjusted for inflation, from the day she started work at age 22 to when she retired at 63.

Bottom line? This investor could have done very well — or very badly. Far from enjoying a smooth “glide path” to a secure retirement, she could have retired with as little as $50,000 in savings or as much as $211,000. She could have ended up with a retirement annuity of $2,400 a year — or $13,100 a year. There was no way of knowing in advance.

That wasn’t all. Arnott found that in most eras, investors would have actually been better off if they had stood this target-date strategy on its head — in other words, if they had started out with 80% bonds, and then took on more risk as they got older, so that they ended up with 80% stocks.

No kidding. Really.

The median person following the target date strategy ended up with $120,000 in savings. The median person who did the opposite, Arnott’s team found, ended up with $148,000. The minimum outcome from doing the opposite was better. The maximum outcome of doing the opposite was also better.

Why might this be? A moment’s thought can explain that. Many of these investors would have ended up betting big on the stock market late in their career, when they had big portfolios.

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Arnott’s simulation has its own limitations. For example, he assumed the investor invested the same amount — adjusted for inflation — each year. And a sample of 141 years is still only a sample. Many of Arnott’s results were skewed by the massive bull market (in stocks and bonds) since 1982.

Arnott is not proposing a new holy grail to replace the old one. These results since 1871, he notes, do not tell us what the future will hold. But they do challenge the naive and simplistic investment idea that stocks are always risky, that bonds are safe, and that you should always invest less in stocks, and more in bonds, as you get older.

Today stocks and bonds are much more expensive, in relation to dividends and coupons, than in the past. Annuity rates are also lower than in the past, and life expectancy is longer. From this, it is possible to derive a few legitimate mathematical conclusions. Investment returns from stocks and bonds must necessarily be lower in the future than in the past. And as Arnott points out, people will need to save more, and work longer, if they want to retire in comfort.

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